But why do you actually make so much money in private equity? What makes it so profitable?

Does it depend on the type of fund you’re at? Who gets paid what, and when? Will it last for the next 20 years, or are the industry’s best days behind it?

We’ll get to all of that – and more – but let’s start at the beginning and take it from there.

What Are Private Equity Funds?

Private equity is an umbrella term for different types of investments in private companies or in publicly listed companies that will become private as a result of the investment. That’s what the “private” part refers to – we’re not dealing with investments in the stock of public companies here. The bulk of the investing is done through private equity funds, which are investment schemes.

PE funds are managed by a General Partner (GP) – the firm itself and everyone who works there – and funded by several Limited Partners (LPs) – pension funds, banks, insurance companies, high net worth individuals, etc. – anyone who has enough cash to invest.

In “Cold Call to Closed Deal” the GP is the firm that the protagonist is working at, and the Limited Partners are people like Paul and Simon who invest in PE funds themselves.

The GP provides a portion of the capital (at least 1%) and some funds also use debt to finance their investments.

The size of PE funds varies widely from approximately $100M (sometimes less) to tens of billions; the size depends on the type of fund (buyout funds are bigger), the reputation of the GP (top firms with strong track records have an easier time raising large funds) and the region (some countries have smaller funds than others).

Growth Capital Funds invest in reasonably mature companies that are looking to scale-up their operations (organically or through an acquisition) or penetrate new markets; these are somewhere in between LBO funds and VC funds in terms of assets under management and investment size. Examples are Summit Partners, JMI, and TA Associates.

Funds tend to be classified in specific buckets, but the sky’s the limit when setting a fund’s strategy! Many firms have also expanded into different strategies over the years, or started new spin-off firms that make different types of investments.

How Are PE Funds Structured?

A private equity firm, as the General Partner (GP), raises a private equity fund by soliciting investments from various investors (institutional investors and high net worth individuals) known as Limited Partners (LPs).

Private equity firms usually manage several funds (depending on the size of the firm) and attempt to raise a new fund every few years. Each fund invests in a number of companies, known as portfolio companies.

The role of the LPs is usually passive and is limited to providing the capital. As such, LPs are not consulted about investment decisions and they rely on the GP to monetize the investments.

Funds are set up as Limited Partnerships between one GP and a number of LPs. The parties will agree on a number of terms specified in a Limited Partnership Agreement (LPA), which often exceeds 100 pages. Each LP can also request specific conditions in a side letter. The LPs have a limited liability corresponding to their commitment to the fund, while the liability of the GP is unlimited.

Important terms agreed upon in the LPA include the term of the fund (usually 10 years + 2 possible one-year extensions); the management fee (usually 1.5 to 2% p.a.), the distribution waterfall (i.e. the way profits are split and distributed), LPs & GP rights and obligations, and limitations imposed on the GP (e.g. type & size of investments, geography, diversification requirements).

Show Me the Money! Where’s the Money?! I Want My Bonus!

So let’s get down to what you’ve been waiting for: why do you make so much money, and who gets what?

But PE firms make (most of) their money by exiting their investments and selling companies for a higher price than what they paid to purchase them.

The profits are split according to a distribution waterfall (the portion received by the GP is referred to as the carried interest or carry – usually 20%) and the GP also receives management fees.

Management Fees

When private equity was first beginning, firms charged the LPs a management fee to “keep the lights on” and cover the fund’s operating costs before they had invested in anything; unlike a normal business, it might take a new PE firm years and years to realize a profit.

Decades later, that same management fee has persisted and is mostly used to pay salaries: a common formula is 1.5% to 2% of the committed fund size (paid to the GP by the LPs) during the investment period (i.e. the period during which new investments are allowed – usually the first 5 years), with a decreasing schedule afterwards.

For example, after the 5th year, the fee might decrease by a certain percentage every year or be charged on the net invested capital (i.e. capital invested in active portfolio companies) as opposed to the committed capital.

Management fees represent a significant amount of money over the 10-year life of the fund and are not linked to performance at all. Just imagine: a $100M fund with a 2% management fee would earn $2M per year and a $1B fund would earn $20M per year (for at least 5 years), regardless of their performance!

And that’s why PE firms can afford to pay such high salaries: the biggest funds might have tens of billions under management, and therefore have hundreds of millions each year for employees.

Just as in banking, there are few other expenses so they can afford to pay employees lavishly.

And remember what the headcount at these places is like: even the biggest firms such as Blackstone and KKR only have a few hundred investment professionals.

The average pay could easily top $1 million or more per employee – though of course the senior people always earn more and the juniors always earn less.

The Distribution Waterfall

The management fees explain why PE salaries are so high, even in an average year or when the firm hasn’t had great exits.

But if you want to understand why people like Henry Kravis or Steve Schwarzman can make $500 million+ per year, you need to understand the distribution waterfall.

The most common waterfall is an 80/20 split between the LPs and the GP. This means that the GP receives 20% of the profits – known as the carry (to be split between the firm’s partners and staff), while the LPs receive 80% of the profits (to be split between the LPs according to their contribution to the fund).

In other words, the LPs receive 100% of the capital they have committed to the fund, and for each extra dollar, the GP will receive 20 cents and the LPs, 80 cents.

And that’s why the Partners at the PE firm make so much: they get 20% of the profit, but only contribute 1% to 5% of the total capital.

Just as a simple example of how this works: let’s say that the firm has just raised a $20B fund, and they invest $2B of capital in new companies. A few years later they exit those investments for $3B.

In this scenario, the LPs would get their $2B of capital back (slightly less than that if the GP actually contributed 1-5% of the total), and would then get 80% of that $1B gain, or $800 million.

Then the GP – the Partners at the firm – would get 20% of that $1B gain, or $200 million.

Technically that’s supposed to be split between everyone at the firm, but in reality the most senior Partners rake in the bulk of it – which explains how the top people at the biggest firms in the world consistently make bank.

But you see a second implication as well: if the fund is much smaller or doesn’t perform well, the numbers aren’t nearly as good.

Hurdle Rates

Often the carry is subject to a hurdle rate or preferred return, meaning that the GP must generate a certain annualized return (often around 8%), before being entitled to the carry.

As a simplified example (and assuming no catch-up clause), in the case of a $100M fund, the LPs would first receive $108M and the excess would be split on an 80/20 basis.

But, when the fund is subject to a hurdle rate, the GP is often protected by a catch-up clause. Continuing with the same example, after the LPs have received their $108M, the next $2M would go entirely to the GP (to shift the split back to 80/20 ? the GP gets $2M/$10M of profits = 20%) and any additional profits would be split on an 80/20 basis.

This sounds great and when the fund is very profitable, all parties (especially the GP) can make a ton of money – but frequently the GP doesn’t receive carry in poorly performing funds, and it is not uncommon for LPs to get back less than their committed capital.

You always hear about the outliers that earn absurd amounts of money, but the average case is far less glamorous: not all investments perform well, and you often lose money.

What Do GPs Do to Earn so Much?! Do They Really Deserve It?

GPs get millions in management fees simply for setting up and managing funds, and then 20% of the profits (if any are generated) – no wonder PE salaries are so high!

So what does a GP do to earn so much?

Raise funds from Limited Partners.

Source and execute investments.

Manage and monitor those investments.

Generate returns by exiting investments.

Raising Funds

To stay in business, private equity funds must raise new funds by securing commitments from external investors.

In reality, a larger firm would rely more on outside fundraising people and not quite as much on the firm’s own employees.

Capital Raising – Where Does the Money Come From?

PE funds can be split into 2 categories: captive and independent. In a captive fund, all the capital is provided by the GP, which might be a bank, an insurance company, a pension plan or a wealthy individual.

In the case of an independent fund, the GP provides a portion of the capital (often 1 to 5%) and raises the remainder from the parties above, reaching out to several LPs in order to secure capital commitments. The GP can also use the services of a placement agent, which is basically an external fundraising team.

A substantial commitment is required from any LP – usually north of $ 1M, and often more – so that only wealthy people who know what they’re doing can invest.

LPs commit to a certain amount, but do not disburse the full amount on day 1. The capital is drawn progressively by the GP from the LPs through capital calls, as investments in companies are made. The commitment is referred to as the committed capital, while the disbursed portion is the contributed capital.

Funds often have a first close and a final close. When the first close is reached, the fund can start investing in companies, but it is still possible for new investors to join the fund (usually for one year). Once the final close is reached, new investors can no longer join in.

Sourcing and Making Investments

Key factors to consider include the product/service & strategy, the team, the industry, the entry valuation and the exit prospects.

Deal flow (prospective investments) can be generated by the firm’s reputation (companies will reach out to the firm), internal staff (who will reach out to interesting companies through their contact network or cold-calling) or investment banks (who represent the company seeking capital and will often run an auction process).

To have access to good proprietary deal flow (i.e. access to deals before other prospective acquirers), the GP maintains good relationships with bankers, advisers and key people in the industry.

Once an interesting investment has been identified, the team then conducts due diligence to evaluate the company’s business model & strategy, team, market, financials, risks, and so on. If no “deal killers” are uncovered, they’ll seek approval from the GP’s investment committee, negotiate final terms, and make the investment.

The level of involvement depends on size of the stake purchased – generally, the smaller the ownership stake, the less involved the GP will be. The GP must also monitor the progress and valuation of its portfolio companies and provide updates to the LPs, usually on a quarterly basis.

Generating Returns by Exiting Investments

The ultimate goal and raison d’être for a PE firm!

The usual exit horizon is approximately 3 to 7 years, but it can also be more or less if there’s a solid, strategic reason to do so.

The IRR is time sensitive, while the multiple of cost is not. For example, if a $20M investment is sold for $40M (a) after 1 year: MC = 2x and IRR= 100%, (b) after 3 years: MC = 2x and IRR= 26%, and (c) after 5 years: MC = 2x and IRR= 15%.

The short answer is yes, at least for the foreseeable future. There has always been talk that LPs will start to demand a different management fee structure and a more favorable distribution waterfall, but nothing supports those changes at the moment.

Even if management fees somehow dropped by 50%, the average per-employee pay would still be close to $1 million – more than almost any other industry, and PE firms themselves would still have few expenses.

And even if the distribution waterfall shifted to 90/10 or 85/15, Partners would still make a ton of money on good investments.

Pay at investment banks, especially in areas like sales & trading, is far more likely to fall in the future because banks are much larger than PE firms and draw more government scrutiny and regulation.

So even if it’s doomsday and pay at banks has fallen dramatically, you’ll still earn something in private equity – even if the firm itself has to shut down due to poor investments.

Stay Tuned…

You’ve now learned pretty much all the basic information and even some of the lingo you need to appear well-informed during a PE interview!

Stay tuned for the next feature in this series, where we’ll explore PE in emerging markets – the hot markets & trends; the key differences; and the risks & rewards involved.

About the Author

The Financial Globe-Trotter started investing at age 11, after drawing inspiration from It's a Wonderful Life. She's from Canada and has worked in investment banking and private equity around the world.

Thank you for the informative article! I was wondering if you could provide some insight on how private equity firms manage their contacts? Do they use a CRM system/software? How do they stay in touch and follow up with people in their portfolio companies and keep everything organized? Any information would be helpful.

Hi M&I – love the site, would it be possible to have an article or an interview on PE placement agents? Not much information out there, but seems like they play quite an important part in the fundraising process.
Thanks,

Hello Brian. I want to thank you for the wealth of information this website offers to readers. I wanted to know what advice you would give to an undergraduate student at a target school who is primarily interested in investment banking for the money. I have no problem saying I am looking for a job on Wall St. for the money, because when I think about the money I could potentially earn I’m not thinking about the cars or the houses I want to buy, I am thinking about how I could retire my dad or take care of my siblings’ college tuition. I am trying to make 1-3 million dollars as fast as possible so I can take care of my family. People are probably going to laugh at my motivation and aspiration, but that is what drives me. I just would like some feedback and maybe a path forward, if there is one. I’m sorry for the length. Thanks.

That’s honest of you though I’d really focus on talking about how the work motivates you and why you want to be doing deals. Talk about your longer term goals of progressing in the industry. This will sound more convincing.

I was reading your other PE post (http://www.mergersandinquisitions.com/private-equity-promised-land/) and was wondering what ‘worked in industry’ meant on the pie chart? I’m wondering if I could work in a top tech firm (e.g. Facebook, Google) in say a sales strategy/operations type role or something else technical/business related (which involves modelling but also looking at the operational side of the business), do a top MBA, then transfer over to PE? Or will this not be possible and I should aim for IBD or MBB? Would it mean aiming for MM PE firms if I go down this route? Thanks.

Appreciate the reply. Wondering if this applies globally or for the USA?
Would it be tougher to get into a good/top BB for IBD or a top PE shop with top tech firm experience + top MBA vs MM firm IBD (good name but not BB or elite boutique) to top PE?

What about special purpose acquisition corp? Or SPAC. The guy I know in PE said this is what they are currently doing and that they are getting ready to have another SPAC offering. How do they make money this way? Is this a usual way of going about capital raising? Any info you can give would be greatly appreciated

Is there going to be an article on the “financial sponsor” group at investment banks? Is the financial sponsor group there to help private equity firms? If so what does the financial sponsor group do to help private equity firms?

Hi, in the example above “The IRR is time sensitive, while the multiple of cost is not. For example, if a $20M investment is sold for $40M (a) after 1 year: MC = 2x and IRR= 100%, (b) after 3 years: MC = 2x and IRR= 26%, and (c) after 5 years: MC = 2x and IRR= 15%.” How was the IRR of 26 percent after 3 years worked out and how was the IRR of 15 percent after 5 years worked out? I.e how did you get the answer sof 26 percent and 15 percent? Can you go through the calculation for me?

Great article! should serve as a requisite primer for all interested in PE (along with From Cold Call to Closed Deal).

Although not too dissimilar in terms of structure and mechanics, any chance you’ll do any articles along the same lines but on real asset investment management(real estate/infrastructure)? – at least touching on the aspects where it differs form investing in companies.

In the example you stated “For example, if a $20M investment is sold for $40M (a) after 1 year: MC = 2x and IRR= 100%, (b) after 3 years: MC = 2x and IRR= 26%, and (c) after 5 years: MC = 2x and IRR= 15%.” how is the 26 % IRR after 3 years and the 15 % IRR after 5 years calculated? I.w what did you do to get to thoose numbers?

That’s the point of that metric, it’s just a multiple of (capital invested) / (capital received on exit) and is not time-dependent. IRR tells you how good a return it was over *time* and is the ultimate measure of how well it performed. $40M from $20M invested is awesome for 1 year, really good for 3 years, but not as good when you get to the 5-10 year range because in that range you could have invested the money elsewhere and earned a higher return.

Thanks for this very informative piece. A refresher in some parts and fresh knowledge in others. Glad to see it will turn into a series and even more glad to see the next issue will be about emerging markets (for all those who are interested: E&Y has a paper out about PE in Brazil).

What I personally would find interesting, is an article about infrastructure funds (as to me the name Macquarie sounds even more sexy than KKR). Would this be possibility in the future?

Interested in the performance of these PE funds.. especially when you have so many awesome fundamental hedge funds who have the flexibility to invest in a broad range of assets but also have the size to conduct buyouts themselves.

Here’s a response I wrote to dee on this post – Why Investment Banking? He asked a similar question

I’d try to relate a personal story to why I want to do banking (this builds rapport). I’d say that I’m more interested in understanding how to execute M&A deals/IPO processes/pick stocks (depends on which group(s) you’re interviewing for) vs helping companies improve their performance in consulting. Also say that you think IB produces more “tangible results” – bankers typically make far more of an impact than consultants. True, some transactions fall apart, but when they happen you get a new public company or a new conglomerate. By contrast, you never know if the recommendations consultants make will be implemented

The short answer is yes, at least for the foreseeable future. There has always been talk that LPs will start to demand a different management fee structure and a more favorable distribution waterfall, but nothing supports those changes at the moment.”

I understand how the pay structure of PE funds are lucrative despite its performance, but doesn’t this assume the continued viability of private equity itself?

I’ve heard that there’s a movement to change the tax code to make it less exploitable by PE funds using great amounts of debt. Could such a regulatory change derail the PE industry?

Let’s think in finance terms…EBIT…
If taxes increase, less money goes to equity investors, debt holders get the same thing. This however, is only significant if PE wants to get dividends during the project. Valuation is still based on EBITDA or EBIT margins, so in the case of sale prices taxes wont matter. Actually, higher taxes are even better for very leveraged deals…

I have read the article and I still hold the same opinion = nothing will change. While tax on capital gains will likely increase for PE firms, they will certainly “engineer” something to not treat the tax man too well).
First thing that comes to mind: PE firms may hold to their investments longer, and who knows what will change in 5-10 years? This new amendment may be abolished in such a long time.
Secondly, there sure are some “accounting” tricks that deal with it (which I am not familiar with yet).
Finally, managers will still harvest nice bonuses since their bonuses may start to come from SG&A rather than actual net income. LPs will still make decent money especially if you compare to recent roller coasters on the stock market.

I still don’t think it will change much. Yes, taxes may increase, but what do you think PE Partners will do? Go get a job making $100K per year at a normal company?

Even when tax rates were much higher in the 70s investors still… invested.

Maybe if they changed taxes to 99% or something ridiculous it might discourage all investment, but 35% vs. 15% makes a marginal difference at best. Even at a 35% tax rate it’s still more take-home pay than almost any other field.

Since we’re on the subject of Money, Bonuses etc I want to ask you, Have you by any chance seen that documentary ‘inside job’. What do you think of it? I knew the recession was brought on by the greed of brokers, bankers and investors but I had no idea as to the volume of this. And Sales and Trading Guys made ridiculous money sell assets that they were as a bank were betting against. This has actually made me rethink whether I would be able to do that ethically. Is there still that kind of conflict of interest in trading rooms and if so will it ever go away and is there a way to work ethically if it is still there.

Tons of things… too much DD, disagreement on price, wounded egos, pride, back-stabbing and corporate ladder climbing, disagreement on terms like management rollover and/or non-competes, the list goes on. Most deals fall apart. I actually thought of this idea the other day and will write something about it in the future.

Whilst IB clearly seems like the obvious entry point into PE, I’ve also heard that management consulting at a top tier house is a viable pathway, mainly into operationally focused PE firms?

Was wondering in your experience whether many huge PE firms actually do much operational turn around. Or is it all middle market stuff? And if so, do most create their own inhouse team (like Capstone at KKR) or just outsource the work?

MC can work but as you said it’s more limited to operationally focused firms at least in the US. Elsewhere i.e. Europe and emerging markets you see more diverse backgrounds.

Operational turnaround is pretty much a joke for huge PE firms and it’s mostly financial engineering. It tends to only work well for truly distressed companies that need it, which big PE firms stay away from.

To add to that, the operational part of PE deals typically involves the carrot and stick of financial engineering. Put a good management team in place, pile on the debt so management is forced to improve the company or go bust, and provide a big payout at the end if all goes well.

There are, though they can be classified under the categories in the beginning to some extent. We actually have an article on mezzanine coming up soon and maybe something on distressed or turnaround in the future. There is already one on funds of funds if you do a search.

However a secondary and direct porfolio purchase from a fund is totally different from a FoF. A FoF is blind capital, a secondary/direct will look at traditional analysis of portfolio’s already purchased.

Thanks. These are not really once-per-day (more like 2x per week) as that would be impossible for me to manage / there is not enough quality content to sustain that, but I do want to cover more topics in the future.

Yes they truly don’t go unnoticed. I really enjoyed Nicole post about PB. and I look forward to hearing more about her inst sales, ECM and PB experience.
Quick questions Brian I want to buy the NNTK but I want to target places especially boutique and midle market PB’s and places where I can get a inst sales job, in london how many roughly

Yes they truly don’t go unnoticed. I really enjoyed Nicole post about PB. and I look forward to hearing more about her inst sales, ECM and PB experience.
Quick questions Brian I want to buy the NNTK but I want to target places especially boutique and midle market PB’s and places where I can get a inst sales job, in london how many roughly Are in the guide

I am wondering how PE professionals manage their own portfolios (their savings). I have a feeling they do not invest in stocks and bonds, but rather keep their money in cash or buy real estate. An average person is brainwashed with past performance of S&P and Dow and how s/he should invest in “diversified portfolios” including mutual funds. Do you know how PE guys manage their own money? (aside from bottles & models). Thanks.

Most people in finance are horrible at managing their own portfolios / don’t necessarily save much due to excessive spending and lack of time outside of work. Before someone leaves a comment in response to this and says, “But I saved $100K per year! You suck at life,” yes, there are exceptions and some people do save/invest a lot. As to what specifically they invest in, sometimes they have to put their own money to use when investing in companies so that’s part of it, other than that I would imagine they just keep it diversified due to limited time outside of work unless they have a financial planner etc.